Healthcare Finance Research: Basics of Capital Budgeting

Healthcare Finance: Basics of Capital Budgeting
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1] What are net present value and internal rate of return? The net present value (NPV) estimates the value of an investment by subtracting the discounted cash outflows including initial outlay from the discounted cash inflows. The cash flows are discounted to take into account the cost of capital of an investment project and calculate the present value. To calculate the NPV, it is necessary to identify the calculated interest rate (cost of capital) and the future cash flows (Juhasz, 2011). A positive NPV indicates that an investment project is worthwhile, and when evaluating different investments the one with the highest NPV is chosen over others (Ehrhardt & Brigham, 2014).
The internal rate of return (IRR) is the discount rate where the NPV=0 as cash inflows are equal to the cash outflows. Even though, the IRR also begins with identifying the cash flows, there is no discount rate. The IRR depends on the inflows and outflows. The decision criterion involving the IRR focuses on choosing investment projects where the IRR is greater than the hurdle rate/ cost of capital. The IRR has a single discount rate unlike the NPV, and in most cases the two methods result in similar findings. However, when there are unconventional cash flows the NPV is preferred over the IRR.
2] What are advantages and disadvantages of each one?
The Net Present value takes into account all the cash flows when evaluating investments. The cost of capital considers the risk of investing in a project and is necessary to determine the cash flows. Since the NPV discounts the cash flows it considers the time value of money to give a more accurate assessment of project cash flows and maximize wealth (Gitman, Juchau, & Flanagan, 2010). Hence, the NPV approach helps to determine whether the value of an investment will likely increase. The net present value method also considers the investment cash flows before and after the project life span. Nonetheless, there are disadvantages to using the Net Present Value since it is necessary to estimate the discount rate before calculating the net present value. Unlike their, the NPV expresses value in dollars rather than a percentage. The NPV also fails to inform decision makers about the real profitability of an investment project (Juhasz, 2011).
Similar to the NPV, the IRR also shows when the value of investment increases, and the IRR also considers all the project cash flows and the time value of money (Gitman, Juchau, & Flanagan, 2010). Even though, the IRR does not have a discount rate, it informs the decision maker about the real yield of an investment (Juhasz, 2011). There are disadvantages to using the method since the ...